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Opportunity or overcapacity in business development company issuance?
admin | February 7, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The business development company (BDC) subgroup has been active since late 2018, as middle-market lending demand ramped up and a key regulatory change enabled issuers to add roughly a turn of leverage with the approval of their boards. This resulted in a wave of issuance over the past several quarters relative to the small size of the market. Although there has been some upwards ratings migration among the stronger names, the persistently higher-risk lending inherent in the segment means the limited upward mobility for credit is offset by significant downside risk.
Expanding market
Goldman Sachs BDC Inc. (GSBD: Baa3/BBB-) – a business development company (BDC) that is structurally independent of Goldman Sachs – became the most recent issuer in the segment to launch an index-eligible unsecured note offering. The 5-year deal was upsized to $360 million from $300 million, and priced at a level of +230 bp to the 5-year, versus initial price talk of +240.
Exhibit 1: Business development companies (BDCs) vs broad financials (B, BB, BBB-)
Source: Bloomberg/TRACE indications, Amherst Pierpont Securities
Bottom-line: The GSBD deal appears attractively priced relative to the peer group, particularly given the implicit support provided by Goldman Sachs (Exhibit 1). The expectation that Goldman Sachs would help in the event of a capital shortfall boosts the rating from its underlying level of Ba1 to Baa3, and is a backstop of support not seen among the standalone names in the sector, despite their larger size. The new bonds priced wide of generic BB Financial credit (according to Bloomberg fair value curves), as well as peers such as FSK and ARCC, with standalone leverage that is comparable to that of GSBD. This level should move quickly in-line with the rest of the peer group on the follow. In addition, the shift to the use of unsecured debt will likely improve one of the more glaring deficiencies in GSBD’s credit profile versus peers, which is its over-reliance on secured lending.
Notwithstanding the relative value in the new deal, investors should be cautious about positioning too aggressively in the BDC credits. Middle market lending has become an increasingly competitive market, particularly in wake of the late 2018 regulatory changes. This is forcing lenders into more risky loan opportunities, and forcing operators to offer more competitive rates to capture business. This includes the usage of paid-in-kind (PIK) lending structures, which enable borrowers to postpone interest payments to maturity at a penalized rate without defaulting. Typically the rating agencies watch to make sure IG peers in this space keep PIK lending well below 10% of their total loan books, but some have been stretching close to that threshold.
Furthermore, while the IG ratings are supported by current balance sheet postures, the smaller size and burgeoning use of leveraged lending makes them susceptible to rapid deterioration in a down market. The industry is also subject to the risk of decreased appetite for collateralized loan obligation (CLO) issuance, which would take away an increasingly prominent funding vehicle.
Exhibit 2. BDC Peer Analytics
Source: S&P Global Market Intelligence, Bloomberg, company filings, Amherst Pierpont Securities
Some background on BDCs
The segment has generated attention in credit and new issue activity with the passage of the Small Business Credit Availability Act (SBCAA) in late 2018, which enabled BDCs to reduce their asset coverage metrics to 150% from 200%. Several boards approved the measure in the months that followed, which effectively allowed them to add a full turn of leverage – generating activity in the new issue market. Almost the entire IG market consists of paper that has been issued over the past several quarters.
SBCAA was designed to spur small business growth. While it inherently adds some risk to the system, stronger players such as ARCC and ORCC are well-positioned to manage the additional leverage. The rating agencies weighed in on the change last year, so current ratings for most issuers should already take this into account. Although some of the more prominent issuers have experienced upwards ratings migration, investors should be aware that this higher-risk segment of lending is capable of supporting at best low-BBB ratings, with very limited upward mobility for credit versus considerable downside risk.
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